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Leveraged and inverse ETFs: What's the fuss?

Advisers wonder why these exchange-traded funds suddenly have become toxic

As leveraged and inverse exchange-traded funds have come under attack, some advisers wonder what all the fuss is about.

True, not all do-it-yourself investors and even advisers, for that matter, fully understand how the products are reset each day to track their underlying indexes.

But that ignorance is not the fault of the industry, advisers said.

“I feel that the industry has done its job” in explaining the products, said Robert Kargenian, founder of TABR Capital Management LLC, with $144 million under management.

“It's the people using them who haven't taken the time to understand them,” he said.

The Financial Industry Regulatory Authority Inc. triggered a wave of concern about leveraged and inverse ETFs in June when it issued a warning about using the products for longer than one day.

Due to the daily resetting by the products, and the effects of compounding, the sequence of returns is critical, advisers said.

“However, because of all volatility we've seen, if you did buy and hold for an extended period, [the products] didn't always correlate” to the underlying index, said Tom Lydon, president of Global Trends Investments, who manages $79 million.

ETF providers have always explained how the daily resets work, he said.

The volatility of both up and down days has “greatly amplified” what, on the surface, look to be large tracking errors, he said.

“If we'd had a straight compounding move in one direction [like the market moving] down 1% per day” to produce a 50% loss, inverse ETFs would have “worked perfectly,” Mr. Leake said.

ETF providers don't know who their shareholders are, so it's not known how many buyers of leveraged and inverse funds are unsophisticated do-it-yourselfers.

Leveraged funds often end up on the top of performance lists and get a lot of attention, Mr. Lydon said.

“It could be that those [investors] who got the greedies and didn't do their homework may have gotten involved,” he said.

In addition, although advisers may understand how to use the products, that “doesn't always mean they'll be on the right side of the market,” Mr. Lydon said.

Making a wrong-way bet on market direction, or giving up profits with a hedge, doesn't always endear advisers to their clients, he said.

At least one provider, the Direxion Funds, plans to move some products to a monthly reset.

In early July, Direxion filed with the Securities and Exchange Commission a request to change the tracking on its open-end leveraged and inverse funds to a monthly basis, said Bill Franca, executive vice president of distribution at Direxion.

The change would reduce the number of compounding periods, to 12 a year, he said.

The change by Direxion is a good move that “will better reflect investor behavior,” Mr. Leake said.

In the meantime, advisers hope the dust-up over non-traditional ETFs will die down.

“I understand regulators trying to get their arms around [the products] a little more,” Mr. Lydon said. But now that the warning has been made, “the heat will back off of this,” he said.

Mr. Leake thinks liquidation of inverse funds in the wake of the regulatory scare has helped fuel the market rally as hedges have been unwound.

He thinks regulators are trying to look tough after missing the Bernard L. Madoff and Allen Stanford frauds.

“ETFs are not the worst things that have happened to the securities industry,” Mr. Lydon said.